Disney (DIS): the valuation issue

Long-time readers may recall that I became interested in DIS in late 2009, the company acquired Marvel Entertainment, a stock I held, for stock and cash.

corporate structure

I hadn’t looked at DIS for years before that.  I quickly learned that DIS was a conglomerate, that is, a type of company where the most useful analysis comes taking the sum of its constituent parts.

I knew the company’s movie business had been struggling for some time and the theme parks were being hit hard by recession.  Still, I was more than mildly surprised that ESPN (plus other media that we can safely ignore) made up somewhere between 2/3 and 3/4 of DIS’s operating earnings.  Why did they still call it Disney?

multiples

Given that the parks are a highly cyclical business and movies moderately so–meaning the PE applied to those earnings should be relatively low–and that ESPN was showing all the characteristics of a secular growth business–meaning high PE–I thought that ESPN represented at least 80% of the market capitalization of DIS.  (That’s despite the fact that the market would apply a higher than normal multiple to cyclically depressed results).

So DIS was basically ESPN with bells and whistles.

ESPN’s turning point

In 2012, ESPN made a major effort to enter the UK sports entertainment market.  To my mind, this wasn’t a particularly good sign, since it implied ESPN believed the domestic market was maturing.  Worse, ESPN lost the bidding, closing out its path to growth through geographic expansion.

It seemed to me that DIS management, which I regard as excellent, understood clearly what was happening.  It began to redirect corporate cash flow away from ESPN and toward the movie and theme park business, which had better growth prospects, and where it has since had unusually good success.

2014-16 results

Over the past two fiscal years (DIS’s accounting year ends in September), the company’s line of business results look like this:

ESPN +        revenues up by +11.9%, operating earnings by +6%

parks           revenues up by +12%, op earnings  +24%

movies        revenues up by +30%, op earnings +74%

merchandise   revenues up by +4.6%, op earnings +33%.

the valuation issue

ESPN has gone ex growth.  This implies these earnings no longer deserve a premium PE multiple.  To me, the fact that ESPN now treats WWE as a sport (!!) just underlines its troubles.

The other businesses are booming.  But they’re also cyclical.  So while improving efficiency implies multiple expansion, earnings approaching a cyclical high note implies at least some multiple contraction.

Because the two businesses are so different, I think Wall Street is making a mistake in treating earnings from the two as more or less equal.

calculating…

DIS will most likely earn $6 a share or so this fiscal year.  That will be something like $3 from ESPN and $3 from the rest.

Take the parks… first.  Let’s say I’d be willing to pay 18x earnings for their earnings.  If that’s the right number, then these businesses make up $54 a share in DIS value.

Now ESPN.  If we assume that the worst is over for ESPN in terms of subscriber and revenue-per-subscriber losses, we can argue that the future earnings stream looks like a bond’s.  If we think that ESPN should yield, say, 5% (a 20x earnings multiple), that would mean ESPN is worth $60 of DIS’s market cap.  If we’d still on the downslope, that figure could be a lot too high.

$54 + $60 = $114.  Current stock price:  $109.

my bottom line

My back of the envelope calculation for the parks… segment may be a bit too low.  I could also be persuaded that my figure for ESPN is too rich, but it would take a lot to make me want to move the needle higher for it.

Yes, most of DIS’s earnings are US-sourced, so the company could be a big winner from domestic income tax reform.

But if I were to be holding a fully valued stock on the idea of a tax reform boost, I’d prefer one with more solid underpinnings.  At $90, maybe the stock is interesting.  But I think ESPN–the multiple as much as the future earnings–remains a significant risk.

 

 

 

 

Disney (DIS) from 30,000 feet

I’d only followed DIS from afar until the company acquired Marvel Entertainment, which I held in my portfolio, for a combination of stock and cash in late 2009.  I kept the shares I acquired and also bought more while DIS was depressed by critics doubting the wisdom of its move. I’m tempted to write about how wrong that view was, but that’s for another day (not soon).

As I studied DIS’s financials, I found that ESPN accounted for about 75% of the firm’s overall operating profit.  The movie studio, run by a former monorail driver at the theme parks, was a mess.  Income from the parks was depressed by recession.  The Disney brand was also almost completely dependent on female characters, making Disney attractions less appealing to half the adolescent population.  ESPN, on the other hand, was/is the dominant sports cable franchise in the US and was going from strength to strength.  For a moment–until I realized the marketing advantages of having the Disney name in the public eye–I wondered why the company didn’t just rename itself ESPN.

In addition, the simple percentage of earnings seemed to me to understate the importance of ESPN to DIS.  The movie business is typically a hit-or-miss affair and therefore doesn’t merit a premium multiple.  Same with the hotels/theme parks, because they have a lot of operating leverage and are highly sensitive to the business cycle.  So I concluded the key to the DIS story was the progression of its secular powerhouse–and its one high-multiple business–ESPN.  Nothing else mattered that much.  (Of course, I didn’t understand the full power of Marvel, or the turnaround in the Disney studio, or the subsequent acquisition of the Star Wars franchise, but that’s a separate issue.)

In 2012, ESPN began an effort to expand its business in a major way into the EU by bidding large amounts for broadcast rights to major soccer games in the UK.  Incumbent broadcasters, however, realized (correctly) that no matter what the cost it would be cheaper to keep ESPN out of their market than to deal with it once it had a foothold.  So they bid crazy-high prices for the rights. ESPN withdrew.

ESPN’s failure was disappointing in two ways.  A new avenue of growth was closed off.  At the same time, the attempt itself signaled that ESPN believed its existing Americas business was nearing, or entering, maturity.  That’s when I began easing toward the door.

The issues for ESPN–cord-cutting and the high fees ESPN charges–are very clear today.  What I find most surprising is that it took the market three years, and an announcement of subscriber losses by DIS, for the stock market to focus on them.  So much for Wall Street’s ability to anticipate/discount future events, even for a major company.

I don’t think ESPN is helping its long-term future by seeking to boost ratings by having personalities shout at each other in faux debates.  Nor does covering WWE as if it were a real sport.  I think they’re further signs of decay.  My sports-fan sensibilities aside, the real issue is about price.

Suppose every cable subscriber pays $4 a month to get ESPN, but only 15% actually watch sports–or would pay for ESPN if it weren’t part of the basic package.  If so, the real cost per user is closer to $30 a month, most of which is being unwittingly subsidized by non-users.  There’s only one way to find out if current users would be willing to pay $30 for ESPN, which is by removing the service from the bundle everyone must buy, reducing the basic cable charge by $4 a month, and offering ESPN separately.  That’s what the cable companies want–and what ESPN is looking to avoid.

We’re nowhere near the end of this story.  I don’t think the final chapter will be pretty for ESPN.

On the other hand, as I see it, just after the UK rebuffed ESPN, DIS began to direct its ESPN cash flows away from cable and toward building up its film and theme park businesses.  For me, this was the sensible thing to do.  And it confirmed my analysis of the situation with ESPN.

My bottom line:  for four years ESPN has been the cash cow that’s funding DIS’s expansion elsewhere.  Wall Street only realized this twelve months ago.   But DIS’s reinvention of itself is still a work in progress.  Until the market begins to view DIS as an entertainment company that happens to own ESPN rather than ESPN-with-bells-and-whistles the stock will continue to struggle.

 

 

results from Disney (DIS): a lesson in how the market works nowadays

DIS and ESPN

A relative in the movie business called my attention to Marvel Entertainment a few years ago.  When it was acquired by DIS in late 2009, I held onto the stock I got and added more in the mid-$20 range Marvel, of course, has been pure gold for DIS, even though DIS initially went down on fears that DIS had overpaid.  Naturally I sold the stock way too early, in the mid-$60s–acting more like a value investor than a growth stock fan.

My first thought on reading the DIS 10-K, as I acquainted myself with the company,was that the company really should have been named ESPN, since at that time the cable sports network accounted for 2/3 of DIS’s overall operating profit and virtually all of its earnings growth.

red flags about ESPN

Over the past several years, a number of key warning signs have popped up about ESPN, however:

–ESPN decided to expand into the UK, signalling to me that it considered its US franchise on the cusp of maturity

–but ESPN was outbid for soccer rights by locals and effectively terminated its international expansion ideas–not good, either

–DIS began to shift cash flow away from ESPN and toward the movie and theme park business, which I took to be a sign of corporate worries about ESPN’s growth potential, rather than simply diversification for diversification’s sake

–serious discussion has begun over the past year about the demise of cable system bundled pricing, which likely benefits ESPN substantially (I suspect we’ll find out how substantially sooner rather than later)

–since ESPN.com’s recent format change, I find myself almost exclusively using Time Warner’s Bleacher Report for sports information

–personally, although this isn’t the most crucial part of my analysis, I think the progressive dumbing-down of ESPN coverage, in imitation of sports talk radio, to gain a wider audience will backfire.

To sum up,, there has been an increasing collection of evidence that ESPN probably won’t be the same growth engine for DIS that it has been in the past.

Yet…

…DIS shares were down by about 10% in Wednesday trading (in an up market) on the first signs in the earnings report of the factors I’ve just listed.

discounting?

Where was the market’s discounting mechanism, which in the past has been continuously evaluating corporate strategy and factoring worries like the long list I’ve mentioned above into the stock price?

…only on the earnings report, not before

To my mind, DIS trading yesterday is another indicator that information isn’t flowing on Wall Street as fast as it once did.  That’s neither good nor bad;  it’s just the way the game is being played in today’s world.  What we as investors have got to figure out is how to adjust our own behavior to fit altered circumstances.

My initial thought is that it may be riskier than it has been to dabble in down-and-out industries like mining or oil until the final bad news has hit income statements.

 

net neutrality

Happy Veterans Day!!!

On Monday, President Obama made a strong statement in favor of net neutrality, maintaining that the provision of internet access should be a utility service like the provision of water and electricity.  Personally, I think this is common sensical and correct, and it’s the way we should do things if we were starting from scratch.

His statement comes a few days before the Federal Communications Commission will release its newest version of internet rules, one that will likely allow internet service providers to continue to charge extra to big services like Netflix.  Mr. Obama is now on record as opposing what the head of the FCC, Tom Wheeler, is about to do.

I can’t help thinking that the statement is more than a little disingenuous.  It comes just after the election, so voters don’t have a chance to weigh in on the issue.  It also comes less than a year after Mr. Obama appointed Mr. Wheeler, who spent his career working in and lobbying for the biggest ISPs, the cable companies, to head the FCC. (Wikipedia says Mr. Wheeler is in the cable industry Hall of Fame–wireless HOF, too.)  What did Obama expect Wheeler to do?

I don’t have a solution for the net neutrality issue, but I think know where the problem lies.

Government creates utilities when the public interest is best served by having only a small number of companies providing a capital-intensive service.  Certain firm are granted monopolies or near-monopolies in given service areas.  To prevent abuses, the firms’ business focus is restricted and profits are regulated.  Profit growth is (almost always) tied to the increases in new capacity the utility brings into service.

Consumers are charged by the amount of the service they use; utilities are chomping at the bit to provide more and better service.

Almost none of this applies to the cable companies, whose profits, in the short term anyway, can be maximized by doing the opposite–providing the worst service at the highest price (think:  Comcast or Time Warner Cable).  Yes, both the cable companies and their mobile brethren, ATT and Verizon, have the advantage of being able to build their internet presence using their monopoly cable/telephone infrastructure.  But that in itself doesn’t make their ISP services monopolies.

I don’t see any quick fix.  The orthodox economic solution in a case like this is to encourage competition–that is, prevent further consolidation among existing ISPs and provide incentives to new entrants.  Let’s see if Mr. Obama speaks out against the proposed Comcast-TWC merger, which would be his next logical step if he means what he said on Monday.

 

 

 

the Supreme Court ruled against Aereo yesterday

Aereo, the antenna company

As Aereo would describe itself, it’s kind of like a company that rents storage lockers to individuals–only it rents TV antennas.  Each customer has his own individual micro-antenna, located in a central antenna farm.  These micro-antennas receive the free over-the-air broadcasts from the major TV networks and retransmit them over the internet to a customer device, where TV programs can be viewed in real time.

If Aereo had started up ten years ago, this might not have been a big deal.  But in today’s world the TV networks collect hundreds of millions of dollars in annual retransmission fees from cable networks in return for allowing them to stream network content in real time to cable customers.  In the current cord-cutting environment, Aereo offers/ed an easy and cheap way for getting TV content (sports programming is the key) without having a cable subscription.

Aereo had two claims:

–it was acting just as if it were putting a rental antenna on each customer’s roof, only the antenna is located in a warehouse somewhere with good reception, and

–because each customer was choosing what to have streamed to him, even if there were copyright issues, the networks’ beef is with the individual customer, not Aereo.

prior lawsuits

The networks sued Aereo in Federal court in New York   …and lost.  They sued an Aereo knockoff  in Utah   …and won.

Both Aereo and the networks urged the Supreme Court to take the case and decide.

the ruling

The decision, 6 – 3 against Aereo, with the most conservative justices dissenting, came yesterday.

If I understand the ruling (don’t bet the farm that I do), the decision came in a way that Aereo hadn’t expected.

The majority said that back in the day, cable companies set up their own antennas to capture over-the-air network content and deliver it to cable customers without paying the networks for doing so.  Congress expressly made this illegal in 1976, through a revision to the Copyright Act .  So it didn’t matter if Aereo owned one humongous antenna or a gazillion teeny-tiny ones.  It also didn’t matter that the customer ordered his personal antenna to send the content or not.  All that mattered was that Congress outlawed delivering real-time network content without paying retransmission fees.

The majority also made a point of distinguishing real time delivery from time-shifting, where a customer records content for later viewing.

stock market implications

Take the Aereo IPO off your calendar for now.

It’s a big win for the broadcasters, protecting their cable retransmission fees for at least several years.

Unfortunately for them, it also leaves a lot up in the air.  We now know what Aereo can’t do, which is stream network content in real time, or with a brief delay.  But could it stream content with an hour lag?   …or the next day?  What about someone who records copyrighted content and shares it through Dropbox?  Is Dropbox responsible, or is it only the user who’s in trouble?

This case seems to show that operating through a big bunch of teeny antennas is colorful, but provided no legal protection.

My guess is that someone, maybe not Aereo, but someone, will try to revive the service, building in a time delay.  I’m not sure how much people would be willing to pay for time-shifted content, but my hunch is the audience would be surprisingly large.

Anyway, I think this possibility will prevent the content companies from running away to the upside.